SCOTUS

On January 12, 2018, the U.S. Supreme Court granted certiorari over the Eleventh Circuit’s decision in R. Scott Appling v. Lamar, Archer & Cofrin, LLP, which held that a fraudulent statement regarding a single asset may constitute a statement concerning the debtor’s financial condition, thereby allowing a debt incurred in reliance on the false statement to be discharged through a bankruptcy. The Eleventh Circuit’s decision focused on the dichotomy established in sections 523(a)(2)(A) and (B) of the Bankruptcy Code between fraudulent statements regarding the debtor’s “financial condition,” which only prevent the discharge of a debt if the false statement is made in writing, and other fraudulent statements giving rise to a debt, which can prevent a discharge even if the statement is only made orally. R. Scott Appling v. Lamar, Archer & Cofrin, LLP will allow the Supreme Court to address a split between the Circuits on this issue, as the Eleventh Circuit’s ruling is consistent with the approach adopted by the Fourth Circuit,[1] but contrary to the standard adopted by the Fifth, Eighth, and Tenth Circuit’s approach, which holds that a statement about a single asset does not “respect” a debtor’s financial condition as required by 523(a)(2)(A).[2]

The case arises out of an adversary proceeding initiated by Lamar, Archer & Cofrin, LLP (“Lamar”) against one of its clients, R. Scott Appling. Appling incurred certain legal fees when Lamar represented him in lawsuits against the former owners of his business; however, Appling was unable to pay his legal bills when they became due. During a meeting with attorneys from Lamar, Appling conveyed that he was expecting a substantial tax refund, which he represented would be sufficient to pay his outstanding legal bill as well, as to pay any future fees incurred during the ongoing litigation. In reliance of this statement, Lamar continued its representation of Appling and did not take any steps to immediately collect its overdue fees. However, Appling’s statement was false as he only received a modest refund, which he put into his business rather than to satisfy the outstanding legal fees owed to Lamar. Lamar eventually filed suit against Appling to collect the outstanding fees, and Appling subsequently filed for bankruptcy. The central issue is whether Appling’s oral statements regarding his tax refund, which pertained to a single asset, respected his financial condition and is therefore dischargeable.

The Supreme Court’s decision could have ramifications on the discharge of debts in bankruptcy. The narrower interpretation of the statute favored by the majority of circuits will limit the scope of the “financial condition” exception contained in section 523(a)(2)(B). This “gives effect to the fundamental bankruptcy policy that the bankruptcy courts will not provide safe haven for the perpetuators of fraud.”[3] Indeed, the exception was originally conceived by Congress to address certain consumer-finance companies that were deliberately encouraging customers to submit false statements for the purpose of insulating the creditor’s claim from discharge.[4] However, application of the majority view is difficult in practice because it creates “substantial line-drawing problems and may cause unjustified differential treatment of functionally equivalent scenarios.”[5]

On the other hand, applying the broader interpretation put forth by the Eleventh Circuit could promote predictability and accuracy while protecting debtors from abusive credit practices.[6] It encourages creditors to rely on written statements, which are more reliable as evidence, if they later seek an exemption.[7] The office of U.S. Solicitor General advanced this position and filed a brief as Amici Curiae agreeing with the Eleventh Circuit’s ruling. The Solicitor General argued that the broader interpretation best served Congress’s policy goals because it “gives creditors an incentive to create writings before the fact,” which may reduce fraud in the first instance.[8] By creating reliable evidence for future litigation, “such writing helps both the honest debtor prove his honesty and the innocent creditor prove a debtor’s dishonesty.”[9] Nevertheless, the Eleventh Circuit’s interpretation could expand the exception’s reach beyond its intended scope because “virtually every statement by a debtor that induces the delivery of goods or services on credit relates to his ability to pay.”[10] With the “financial condition” exception taking center stage, this Supreme Court decision will certainly be one to watch.

On August 10, 2017, the Supreme Court dismissed the writ of certiorari in PEM Entities LLC v. Levin as improvidently granted. See No. 16-492, 2017 WL 3429146, at *1 (U.S. Aug. 10, 2017). This decision leaves the circuit courts split on the issue of whether to use federal or state law in recharacterizing insider debt as equity, a critical distinction that can be dispositive as to the treatment of debt claims made by insiders of debtors.

Case Background

In PEM Entities LLC, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from Paragon Commercial Bank (the “Loan”). The Debtor subsequently defaulted on the Loan, eventually resulting in foreclosure proceedings. The Debtor, its principal, and other related entities entered into a settlement agreement with the lender. Under the settlement, Paragon Commercial Bank sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for around $1.2 million. Critically, PEM was owned by insiders of the Debtor, relied solely upon principals of the Debtor to negotiate the settlement agreement, and failed to set out formal interest rates and payment schedules with the Debtor after the settlement of the loan. When the Debtor could not maintain liquidity despite PEM’s intervention, the Debtor filed this Chapter 11 case, wherein PEM filed a secured claim for $7 million. The Debtor’s unsecured debtholders moved to recharacterize the secured claim as equity.

Using the 11 factor federal test for recharacterizing insider debt claims laid out in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453 F.3d 225, 231 (4th Cir. 2006), the United States Bankruptcy Court for the Eastern District of North Carolina held that PEM’s claim would be recharacterized as equity rather than debt, moving the claim to lower priority status than the unsecured debtholders. Both the district and circuit courts affirmed on appeal, with the Fourth Circuit signaling that the federal, rather than state, test for recharacterization would be proper and that PEM’s actions, while arguably debt in name, was at its core a capital investment in the company’s success rather than the temporary borrowing of money.

The Unresolved Circuit Split

The Supreme Court’s decision to dismiss the writ of certiorari in PEM Entities LLC leaves in place a Circuit split on whether to use federal or state law standards to recharacterize debt. The Sixth, Tenth, Third, and Fourth Circuits all use a multi-factor test similar to the one used in PEM Entities, LLC that looks beyond form and to the substance of the transaction to decide whether it should be categorized as debt or equity.[1] Similarly, the Eleventh Circuit applies a two-prong federal standard that also attempts to reach the substance of the transaction.[2] On the other hand, the Fifth and Ninth Circuits have applied an approach to recharacterization based on the state law of the forum.[3] These state laws vary greatly from state to state, but they are often more friendly to debtor insiders who invest in debt and look to the form of the transaction rather than the substance.

Reason for Dismissal

The circumstances of the dismissal further dampen the hopes of a quick resolution to this circuit split. On October 11, 2016, PEM petitioned the Supreme Court for a writ of certiorari to review the Fourth Circuit decision on the issue of whether federal or state law should be applied to recharacterize debt as equity. On June 27, 2017, this writ was granted only to be dismissed as improvidently granted six weeks later, prior to merits briefing, on August 10, 2017. The Supreme Court is not obligated to explain its reasoning for dismissing certiorari and did not here. Usually, certiorari is dismissed as improvidently granted if a party attempts to change its argument in its merits brief, if the dispute seems overly fact determinative, or if the Justices believe that the case has secondary issues that may prevent the court from reaching the merits also known as “vehicle” problems.

Here, certiorari was dismissed shortly after the parties filed a joint motion to confirm party status on July 21, 2017. The original respondents for this action had settled a state court action which caused them to cease having a stake in the outcome of this case. Instead, the parties moved the court for the Debtor to step into the unsecured debtors shoes as the respondents in this action, as they had a continued interest in defending the judgment below. Given the short period of time between the filing of this motion and the dismissal of certiorari as improvidently granted, as well as the fact that merits briefing was never even completed, it is likely that the Court dismissed this case due to “vehicle” issues. That is, the Court decided that, due to the complexity of the party’s status and procedural posture, the likelihood that the Court would not reach the merits of the action had risen and it was no longer worth the risk of using its limited resources to hear the case. This issue may continue to hamper attempts to bring the issue of this circuit split to the Supreme Court, as the interconnected and complex nature of relationships between parties in cases dealing with recharacterizing insider debt as equity rarely make the best simple and clear-cut vehicles for Supreme Court rulings.

[2]. In re N & D Properties, Inc., 799 F.2d 726, 733 (11th Cir. 1986) (two-pronged test, shareholder loans may be deemed capital contributions “where the trustee proves initial undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”).

Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code. The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer.[1] The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.

Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor. The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers. Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities. It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”[2]

The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford Downs, a racino industry competitor. The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.

The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection: a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit.[3] On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers.[4] The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor.[5] Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.

Bankruptcy practitioners and scholars are watching this case with great interest. The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose.[6] Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents. These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place.[7] They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.[8]

The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems. The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending. The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners,[9] and the Tribune unsecured creditors submitted a brief in support of Respondent.[10]

On October 11, 2016, the United States Supreme Court granted certiorari to a debt collection agency in its appeal from the Eleventh Circuit case Johnson v. Midland Funding, LLC.[1] In Johnson, the Eleventh Circuit affirmed its decision in Crawford v. LVNV Funding, LLC,[2] which held that a debt collector violates the Fair Debt Collection Practices Act (the “FDCPA”) when it files a proof of claim in a bankruptcy case on a debt that it knows to be time-barred. In view of the emerging circuit split, the Supreme Court agreed to hear the case in order to resolve two issues: (1) whether the filing of a time-barred proof of claim in a bankruptcy proceeding exposes a debt-collection creditor to liability under the FDCPA and (2) whether the Bankruptcy Code, which governs and permits the filing of proofs of claim in bankruptcy, precludes a cause of action under the FDCPA for the filing of a time-barred proof of claim in a bankruptcy proceeding.

In Johnson, which originated in the District Court for the Southern District of Alabama, plaintiff Aleida Johnson (“Johnson”) filed a Chapter 13 bankruptcy petition in March 2014. In May 2014, a debt collection agency—Midland Funding, LLC (“Midland”)—filed a proof of claim in Johnson’s bankruptcy proceeding for an amount of $1,879.71.[3] This debt accrued over ten years before Johnson filed for bankruptcy and its collection was time-barred by Alabama’s statute of limitations, which permits a creditor only six years to collect an overdue debt.[4] Johnson brought suit against Midland’s filing of the proof of claim under the FDCPA, which provides that “[a] debt collector may not use any false, deceptive, or misleading representation or means in connection with the collection of any debt.”[5] This prohibition encompasses an attempt to collect a debt that is not permitted by law.[6] Johnson argued that pursuant to the language of the statute, Midland’s time-barred proof of claim was “unfair, unconscionable, deceptive, and misleading in violation of the FDCPA.”[7]

Midland promptly moved to dismiss Johnson’s FDCPA suit. The District Court granted the motion to dismiss, finding that the Bankruptcy Code’s affirmative authorization for creditors to file a proof of claim—regardless of whether it is time-barred—was in direct conflict with the FDCPA’s prohibition on debt collectors filing a time-barred claim. Under the doctrine of implied repeal, the District Court found that the later-enacted Bankruptcy Code effectively repealed the conflicting provision under the FDCPA and precluded debtors from challenging that practice as a violation of the FDCPA in a bankruptcy proceeding.[8]

The Eleventh Circuit reversed the District Court’s decision, holding that “[t]he Bankruptcy Code does not preclude an FDCPA claim in the context of a Chapter 13 Bankruptcy when a debt collector files a proof of claim it knows to be time-barred. . . . [W]hen a particular type of creditor—a designated ‘debt collector’ under the FDCPA—files a knowingly time-barred proof of claim in a debtor’s Chapter 13 bankruptcy, that debt collector will be vulnerable to a claim under the FDCPA.”[9] Under the Eleventh Circuit’s analysis, the allegedly conflicting provisions of the Bankruptcy Code and the FDCPA could co-exist harmoniously, and the presence of a “positive repugnancy” between the statutes necessitating application of the un-favored doctrine of implied repeal was lacking.[10] Thus, although the Bankruptcy Code guarantees a creditor’s right to file a proof of claim they know to be time-barred by the statute of limitations, those creditors do not thereby gain immunity from the consequences of filing those claims.[11] The Court rejected Midland’s assertion that such an interpretation would effectively force a debt collector to “surrender[] its right to file a proof of claim.”[12] The court likened this scenario to filing a frivolous lawsuit, stating that “[i]f a debt collector chooses to file a time-barred claim, he is simply opening himself up to a potential lawsuit for an FDCPA violation. This result is comparable to a party choosing to file a frivolous lawsuit. There is nothing to stop the filing, but afterwards the filer may face sanctions.”[13] Accordingly, the Eleventh Circuit found that the FDCPA lays over the top of the Bankruptcy Code’s regime, so as to provide an additional layer of protection to debtors against a particular kind of creditor—debt collectors.[14]

The Court in Johnson makes clear that its holding is limited in scope and should not have far-reaching consequences for most creditors. Most importantly, the Court acknowledges that the FDCPA’s prohibitions do not reach all creditors—the statute only applies to “debt collectors,” which are a narrow subset of the universe of creditors that might file proofs of claim in a bankruptcy proceeding.[15] Furthermore, the FDCPA provides a safe harbor for debt collectors who unintentionally or in good-faith file a time-barred proof of claim.[16] Thus, a debt collector who files a time-barred proof of claim may escape liability by showing that the violation was not intentional and resulted from a bona-fide error.[17] These two limitations ensure that regardless of how the Supreme Court resolves this circuit split, there will not be a chilling effect on the submission of proofs of claims by the vast majority of creditors.

Although the direct impact of the Johnson ruling may be restricted to a limited creditor base, recent Supreme Court rulings involving bankruptcy cases have had broader knock-on effects on bankruptcy jurisprudence (and jurisdiction), and a decision on preemption as it relates to the Bankruptcy Code has the potential for a significant impact on various aspects of procedural and substantive bankruptcy law outside of the limited issue of the interplay of the FDCPA and the Bankruptcy Code. Accordingly, visit HHR’s Bankruptcy Report for future updates on this case and its potentially broader impact.

Yesterday, the Supreme Court granted certiorari in Czyzewski v. Jevic Holding Corp (“Jevic”). As previously reported, Jevic addressed whether a bankruptcy court can approve a settlement agreement that provides for distributions that violate the absolute priority rules as part of the structured dismissal of a chapter 11 proceeding. The Third Circuit held that such structured dismissals were appropriate even when they provided for distributions that do not strictly comply with the Bankruptcy Code’s absolute priority schemes. The Third Circuit’s ruling is consistent with the Second Circuit’s holding in In re Iridium Operating LLC,[1]which held that such structured dismissals may be appropriate if they are justified by other factors, but put the Third Circuit in conflict with the Fifth Circuit, which held in Matter of AWECO, Inc.[2]that it was inappropriate to approve a structured dismissal that did not strictly comply with the absolute priority rule. The Supreme Court will now address this circuit split and decide whether the flexibility offered to debtors (and some creditors) by structured dismissals outweighs that impact that such dismissals can have on the rights of other creditors and interested parties as discussed in our prior post. The Supreme Court’s decision may also have a broader impact on non-priority distributions more generally and could affect the permissibility of “gift plans,” which are similar to the structured dismissals in Jevic as they often provide for secured or senior creditors to make payments to junior creditors in order to garner support for chapter 11 plans. Check back with the HHR Bankruptcy Report as we continue to cover the briefing, developments, and potential impact of Jevic.

Last summer, the HHR Bankruptcy Report analyzed the Third Circuit’s ruling in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1]which approved, as part of the structured dismissal of a chapter 11 proceeding, a settlement agreement that allowed distributions that violated the absolute priority rule. Following the Third Circuit’s ruling, the aggrieved priority creditors filed a writ of certiorari in the hope that the Supreme Court would address the split between the Courts of Appeals as to whether settlements must follow the absolute priority rule.[2] Now, in response to an invitation from the Supreme Court, the Solicitor General has submitted an amicus brief on behalf of the United States encouraging the Court to grant certiorari and to overturn the Third Circuit’s ruling.

The United State government has a particular and somewhat unique interest in having the Supreme Court review the Third Circuit’s decision. Federal taxing authorities (e.g. the IRS) are granted either second priority or eighth priority claims by the Bankruptcy Code depending on whether the tax obligation arose pre or post-petition. Accordingly, the government recognizes a real danger that, as a result of the Third Circuit’s ruling, debtors could collude with junior creditors to “squeeze out” government tax claims with a higher priority.

At issue in Jevic was the approval of a settlement agreement between the debtor, the Unsecured Creditors’ Committee and defendants to fraudulent transfer actions, that provided, in part, for (i) distributions to certain administrative and unsecured creditors as part of a structured dismissal of the chapter 11 proceeding, but did not provide for (ii) distributions to the debtor’s former employees who held higher priority claims arising from WARN Act liability. The former employees objected to the approval of the settlement on the ground that a bankruptcy court cannot approve a settlement and related structured dismissal of the case that does not comply with the order of priorities set out in section 507 of the Bankruptcy Code. Relying on the fact that it was highly unlikely that the debtor would confirm a plan of reorganization or that the employees would receive any distribution in a chapter 7 liquidation, the Third Circuit rejected the employees’ argument and held that a chapter 11 proceeding may be resolved, in rare circumstances such as those presented in the Jevic proceeding, through a structured dismissal that deviates from the Bankruptcy Code’s priority scheme.

The Solicitor General argued in his amicus brief that the Third Circuit had erred in reaching its holding for a number of reasons. First, the order of priorities established by the bankruptcy code reflects Congress’s detailed balancing of the rights and expectations of various creditor groups, and that by approving a settlement that deviated from this order of priorities, the bankruptcy court was upending “that carefully balanced system.” The Solicitor General noted that this outcome was particularly incongruous when compared to the requirements for chapter 11 plan confirmations and chapter 7 liquidations where priority creditors must be paid first (unless they consent to impairment). Second, the Solicitor General disagreed with the Third Circuit’s reasoning that a deviation from the Bankruptcy Code’s priority scheme was justified by the fact that the employees would not be prejudiced by the settlement because there was no prospect of a chapter 11 plan being confirmed or of a distribution to priority creditors if the case was converted to a chapter 7 liquidation (i.e. the employee creditors would be in the same position whether or not the settlement was approved). The Solicitor General noted that if the case had “simply been dismissed” pursuant to section 1112 of the Code, the employees could have pursued a fraudulent –conveyance action against the settling defendants on a derivative basis as creditors of Jevic. So rather than being outcome neutral, the employee creditors were being directly deprived of a potential source of recovery. The Solicitor General also argued that granting certiorari was appropriate in this case because of the existing split between the Circuitx on this issue, as well as the real and significant impact the ruling could have on the rights of creditors in future proceedings.

The Solicitor General’s amicus brief highlights the potentially wide impact of the Third Circuit’s ruling, despite the court’s attempt to limit its holding to cases where “specific and equitable grounds” justify deviation from the priority scheme. It is conceivable that in nearly every case where a debtor is administratively insolvent, a justification could be found for deviating from the absolute priority rule under the Third Circuit’s ruling. In those circumstances, debtors will be able to apply strong bargaining pressure on priority creditors to accept reduced claim amounts, less the debtor strike a settlement with other junior creditors of the case that cuts out the recalcitrant priority creditor entirely. Additionally, in light of the Circuit split on the issue, the Third Circuit’s ruling raises forum shopping concerns, as debtors (many of whom are organized under the laws of Delaware) will be more likely to commence proceedings in the Delaware bankruptcy court, if only to ensure themselves the benefit of the debtor-friendly rule adopted by the Third Circuit.

Check back with us in the future as we will to continue to cover developments in Jevic.

[2]Compare In re AWECO, Inc 725 F.2d 293 (5th Cir 1984)(finding that a bankruptcy court abuses its discretion in approving a settlement agreement that does not comply with the absolute priority rule); with In re Irdium Operating LlC, 478 F.3d 452 (2d Cir. 2007) (holding that a settlement may deviate from the absolute priority rule in certain circumstances).

Last November, the HHR Bankruptcy Report reported on the Supreme Court’s grant of the petition for certiorari in Husky International Electronics, Inc. v. Ritz, a case in which the Fifth Circuit had held that “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code (which limits the breadth and effect of a debtor’s discharge) required proof of a false representation. Earlier today, in a 7-1 decision, the Supreme Court issued its opinion, reversing the Fifth Circuit’s holding and ruling that actual fraud encompasses “fraudulent conveyance schemes, even when those schemes do not involve a false representation.”

In holding that actual fraud “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation,” the Supreme Court looked to congressional intent and the historical meaning of actual fraud. As to congressional intent, the Court explained that before 1978, the Bankruptcy Code prohibited debtors from discharging a debt obtained by “false pretenses or false representations.” In the Bankruptcy Reform Act of 1978, Congress changed the statute such that a debtor cannot discharge a debt obtained by “false pretense, a false representation, or actual fraud.” As Justice Sotomayor explained, it can be presumed “that Congress did not intend ‘actual fraud’ to mean the same thing as a ‘false representation,’ as the Fifth Circuit’s holding suggests.”

Turning to the historical meaning of actual fraud, the Court began its analysis by quoting the original Elizabethan language of the one of the first bankruptcy statutes, the Statute of 13 Elizabeth, also known as Fraudulent Conveyances Act of 1571, which “identified as fraud ‘feigned convenous and fraudulent Feoffmentes Gyftes Grauntes Alientations [and] Conveyaunces’ made with “Intent to delaye hynder or defraude Creditors.’” The Court noted that the principles behind the 1571 Act, which make it fraudulent to hide assets from creditors by giving them to one’s family or friends, are still used and “embedded in laws related to fraud today.” This, the Court explained, “clarifies that the common-law term ‘actual fraud’ is broad enough to incorporate a fraudulent conveyance.” Further, the fact that, under the 1571 Act and laws that followed, both the debtor and recipient of the assets are liable for fraud, underscores the notion that a “false representation has never been a required element of ‘actual fraud.’”

The Court also rejected the debtor’s argument that the Court’s interpretation would create a redundancy with section 727(a)(2), which prevents a debtor from discharging all debts if, within the year preceding the filing of the petition, the debtor transferred or concealed its assets for the purposes of hindering, delaying, or defrauding a creditor. The Court noted that the two sections may overlap, but that section 727(a)(2) is broader in scope because it prevents an offending debtor from discharging all debt in bankruptcy, and is narrower in timing as it applies only if the debtor fraudulently conveys assets within a year preceding the filing of the petition. Therefore, unlike section 727(a)(2), section 523(a)(2)(A) is tailored as a remedy for behavior connected only to specific debts.

In dissent, Justice Thomas opined that “actual fraud” in section 523(a)(2)(A) “does not apply so expansively” to include fraudulent transfer schemes effectuated without any false representation. Although he agreed with the majority that the common law definition of “actual fraud” included fraudulent transfers, he explained that the general rule that a common law term of art should be given its established common law meaning must give way where the meaning does not fit. Here, according to Justice Thomas, “context dictates” that actual fraud does not include fraudulent transfers because that meaning fails to fit with the rest of section 523(a)(2).

A request for unanimous consent made on Wednesday, December 9th in the Senate to a bill that would allow Puerto Rico to declare bankruptcy was unsuccessful. This prevents prompt passage of the proposed bill by the Senate to extend Chapter 9 of the Bankruptcy Code, which allows municipalities to declare bankruptcy but is not available to Puerto Rico due to its status as a US Commonwealth. The move does not prevent the bill from being considered and voted on through the normal Senate legislative process. Legislation to extend Chapter 9 to Puerto Rico remains pending in both the House and the Senate, but its prospects remain ambiguous adding further uncertainty to the ongoing Puerto Rico financial crisis.

This bill comes on the heels of the Supreme Court’s recent decision to grant certiorari to Puerto Rico’s appeal of the First Circuit’s decision upholding the lower court’s decision[/link] striking down the Recovery Act, a law passed by Puerto Rico to provide a bankruptcy process for some local public corporations. While the First Circuit upheld the decision striking down the Recovery Act as pre-empted by the Bankruptcy Code, its ruling has been used to support the legislative push to extend Chapter 9 to Puerto Rico.

The situation with Puerto Rico remains fluid and the HHR Bankruptcy Report will continue to monitor the situation and provide updates.

Earlier this month the Supreme Court granted certiorari to hear the Fifth Circuit case Husky International Electronics, Inc. v. Ritz, which originated in the United States Bankruptcy Court for the Southern District of Texas. The Fifth Circuit’s decision interprets “actual fraud” in the context of an exception to a debtor’s discharge that would require a creditor to prove that the debtor made a false representation. As the decision stands, this interpretation would make it more difficult for creditors to prove actual fraud when debtors transfer assets with the intent of hindering payments to creditors, making it easier for debtors to place assets out of creditors’ reach.

The question presented to the Supreme Court focuses on the “actual fraud” exception to discharge under § 532(a)(2)(A) of the bankruptcy code, and whether this exception applies only when the debtor has made a false representation, or whether the “actual fraud” exception also applies if the debtor deliberately obtained money through a fraudulent transfer scheme that was actually intended to cheat a creditor.

In Husky, Husky International Electronics, Inc. (“Husky”) sold and delivered goods to Chrysalis Manufacturing Corp. (“Chrysalis”), which the debtor, Daniel Lee Ritz, Jr. controlled.[1] Chrysalis failed to pay for the goods purchased from Husky, leaving $163,999.38 as the total amount of Chrysalis’ unpaid debt to Husky.[2] Between November 2006 and May 2007, Ritz transferred millions of dollars from Chrysalis to seven other entities he controlled and owned.[3] Husky sought to hold Ritz personally liable and sued him for the debt of Chrysalis in May 2009.[4] Seven months later, Ritz filed a chapter 7 petition in the United States Bankruptcy Court for the Southern District of Texas.[5] Husky then initiated an adversary proceeding and objected to the discharge of Ritz’s alleged debt.[6] The bankruptcy court held a trial on the matter and found that the transfers Ritz made “were not made for reasonably equivalent value” and that Husky suffered damages in the amount of the debt owed by Ritz.[7] However, the court found that the “actual fraud” exception to discharge did not apply because Husky failed to show that Ritz made a false representation to Husky and therefore Ritz could not have perpetuated an “actual fraud.”[8] On appeal, the district court affirmed the bankruptcy court’s decision, holding that “actual fraud under 11 U.S.C. § 523(a)(2)(A) . . . requires a misrepresentation.”[9]

The Fifth Circuit agreed with the bankruptcy court and district court and held “that a representation is a necessary prerequisite for a showing of ‘actual fraud’” and because there was no evidence of a representation, § 523(a)(2)(A) does not bar the discharge of the debt.[10] The court rejected the Seventh Circuit’s interpretation of § 523(a)(2)(A) in McClellan v. Cantrell,[11] which explained that because § 523(a)(2)(A) covers both actual fraud and false representations, the statute makes clear that the former is broader than the latter, and therefore a misrepresentation is not necessary for § 523(a)(2)(A) to bar the discharge of a debt. The Fifth Circuit explained that this interpretation is in tension with Supreme Court precedent and is inconsistent with previous decisions of the Fifth Circuit.[12] The court explained that both prior to and subsequent to McClellan, the Fifth Circuit has stated that “to prove nondischargeability under an ‘actual fraud’ theory, the objecting creditor must prove” that [] the debtor made misrepresentations.[13]

Husky presents a circuit split for the Supreme Court to review. After the Fifth Circuit issued its decision, the First Circuit issued its decision in Sauer, Inc. v. Lawson.[14] In Sauer, the First Circuit joined the Seventh Circuit in finding that § 523(a)(2)(A) “extends beyond debts incurred through fraudulent misrepresentations to also include debts incurred as a result of accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor’s creditors.”[15] In its petition for certiorari, Husky argued that the Fifth Circuit’s decision “creates a roadmap for dishonest debtors to cheat creditors through deliberate fraudulent-transfer schemes, and then to escape liability through discharge in bankruptcy.”[16] In opposition to appellant’s petition for certiorari, Ritz argued that the decision does not warrant the Supreme Court’s review at this time, and that even if the Court resolved the question in Husky’s favor, Husky would not get the relief it seeks because under Texas law, “actual fraud” requires a misrepresentation.[17] Oral arguments are expected to be heard during the first half of 2016. Visit HHR’s Bankruptcy Report for future updates on this case.

In the beginning of the opinion he wrote for Stern v. Marshall, Chief Justice Roberts referenced Charles Dickens’ Bleak House, in which Dickens gives a grim description of a lawsuit litigated in a foggy courtroom.[1] In resolving the tumultuous Stern dispute, the Supreme Court created a new fogginess in bankruptcy courtrooms as to the exact contours and scope of a bankruptcy courts’ authority. As our readers are aware, the Supreme Court and the various Circuit Courts have issued a number of opinions in the wake of Stern to clarify the exact parameters of a bankruptcy court powers and the recent opinion by the Fourth Circuit in In re Lewis addressing the specific power of a bankruptcy court to discipline attorneys further helps clear the proverbial fog surrounding the bankruptcy courts’ powers.[2]

In In re Lewis, Mr. Lewis was the attorney to a debtor in bankruptcy.[3] The Bankruptcy Administrator observed several discrepancies in Mr. Lewis’ representation, prompting the Bankruptcy Court to sanction and temporarily suspend Mr. Lewis from further proceedings.[4] On appeal, Mr. Lewis contended that the court did not have the authority, as an Article I tribunal, to suspend his bar privileges or to sanction him.[5] Relying on Stern, he argued that the court did not possess the authority to rule on disciplinary matters against him.[6] The Fourth Circuit disagreed.[7]

The Court of Appeals explained that the Bankruptcy Court appropriately exercised its authority to sanction Lewis for his misconduct.[8] Bankruptcy courts have inherent power, “‘incidental to all courts’ to ‘discipline attorneys who appear before it,’”[9] including “issu[ing] any order, process, or judgment that is necessary or appropriate to carry out the provisions of [Title 11] or to prevent an abuse of power”[10] and suspending or disbarring attorneys from their court.[11] So, despite any Constitutional restrictions prescribed upon Article I courts, all courts may admonish and discipline those who appear before them.

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Hughes Hubbard’s Corporate Reorganization & Bankruptcy group represents companies, creditors and trustees in complex restructurings—both in and out of court—and in the multiple types of litigation that insolvency proceedings generate.

About Hughes Hubbard

Hughes Hubbard & Reed LLP is an international law firm ranked for 12 years on The American Lawyer’s A-List of what the magazine calls “the top firms among the nation’s legal elite.” The firm was founded in 1888 by the renowned jurist and statesman Charles Evans Hughes.